Progress on lowering inflation in the U.S. has been relatively slow, while domestic demand and payroll growth are showing more resilience than expected. Our base-case forecast for GDP growth remains 2.5% in 2024, unchanged from our forecast in March, and our unemployment rate expectations haven't materially changed.

One key change in our baseline forecast since March is a reduction in the pace of monetary policy easing. We expect a total of 125 basis points of rate cuts by the end of 2025, versus our prior expectation of 200 basis points of cuts.

Our real GDP growth forecast for 2024 of 2.5% on an annual average basis is the same as in 2023, but in fourth-quarter 2024, we expect growth to come in at 1.8%, down from 3.1% in fourth-quarter 2023 (see table 1 and chart 1). The Fed's continued tight monetary-policy stance--and the expected delay in easing--will likely cool economic activity into next year.

A period of below-potential growth should lead unemployment to drift higher in the next couple of years. (The Congressional Budget Office revised up its estimate of real potential growth for the U.S. economy to 2.1%, on average, for 2024-2029, versus 1.8% earlier, mostly reflecting a higher-than-anticipated rate of net immigration from 2021-2026.) The pace of inflation will continue to slow, despite the recent upside inflation surprises. A soft landing remains the most likely scenario, at least into 2025.

Table 1

Chart 1

Slower First-Quarter Growth Masks Strong Domestic Demand

Since our last forecast in late March, the U.S. economy has continued to show remarkable resilience. Economic expansion of 1.3% (annualized) in January-March was less than half the 3.4% in the fourth quarter of last year, but the first-quarter figure masked the underlying strength of domestic demand (see chart 2). Excluding volatile net exports and inventories, final sales to domestic buyers grew 2.5% and private demand expanded 2.8%.

Chart 2

Still, income growth has significantly lagged spending growth since the middle of last year, with American consumers relying on credit and savings. Excess savings are likely depleted for all but the highest-income households, and delinquency rates on credit cards and auto loans now exceed pre-pandemic levels. Higher interest rates have led to soaring interest payments as a share of personal income.

We think consumers will likely rein in their spending more as time goes on. Spending on retail sales (indicative of goods consumption) has flattened--at best--since peaking in 2021 (see chart 3). We expect cost fatigue will slow down spending growth in services as well, if not already. Restaurant spending--a discretionary category--in the first five months of this year has increased materially slower than last year (chart 4).

Chart 3

Chart 4

Parts of business fixed investment outlays (which are interest rate and credit sensitive) continue to underwhelm despite the nonfinancial corporate financing gap overall showing little pressure. For the fifth consecutive quarter, the aggregate working capital funding gap has been negative (i.e., a surplus). The financing gap is the net amount of external financial resources (equity or debt) required for a company to maintain existing outlays.

The latest GDP revisions revealed that growth in equipment outlays (approximately 40% of business investment) slowed to a crawl in first quarter. That said, outlays on intellectual property/intangible assets (another 40% of business investment, and less sensitive to interest rates) remained strong on the back of the technology industry (see chart 5).

Chart 5

Manufacturing Gives Some Positive Signs

The manufacturing sector showed indications of a cyclical rebound in the spring, but also some conflicting signals. Both the Institute for Supply Management's New Orders Index and S&P Global Market Intelligence Purchasing Managers' Index (PMI) started to move into expansion territory (above 50) in the first quarter after a long period of contraction, but they reverted back below 50 in May.

Growth in manufacturers' new orders of nondefense, excluding aircrafts, has been sluggish, at best, year to date (see chart 6). This comes even as industrial production pointed to a rebound in manufacturing production (0.9% month over month) in May and the decline in capacity utilization has halted for the time being.

Chart 6

We have raised our equipment investment forecast slightly but still anticipate sub-2% growth in the second half of 2024 before capital spending picks up steam as capital costs come down in our forecast for next year.

As for nonresidential structures investment (the other 20% of business fixed investment), continued weakness in the Architectural Billings Index points to slower private nonresidential construction outlays in the near term. Private nonresidential spending contracted in April--the third time it contracted this year and the latest evidence that activity might be downshifting. We forecast a slowdown in commercial construction investment growth this year from last year's torrid pace as higher interest rates, stringent lending conditions, and rising vacancy rates continue to weigh on commercial construction.

That said, manufacturing projects (a part of commercial construction) remain a bright spot in the development landscape (see chart 7). The high-tech building boom, concentrated in the computer, electronic, and electrical (including semiconductors) manufacturing sector, has helped firm up overall private nonresidential spending (see chart 8), largely because of supportive fiscal policy (CHIPS Act passed in 2022).

Chart 7

Chart 8

High Mortgage Rates Continue To Take A Toll

Meanwhile, after a brief rebound in residential investment early in the year, higher mortgage rates (7% average in April and May) continue to constrain the residential sector, evidenced by weaker-than-expected housing starts and home sales in April and May (see chart 9). Weakening home re-sales imply lower broker commissions, while disappointing foot traffic and higher rates have also soured homebuilders' confidence in May and June. Also, a slip in the number of permits in April and May implies further erosion in residential investment in the coming quarters, though rate cuts should foster stronger growth next year onward.

Less affordable single-family housing has helped boost multifamily (rental) demand, but multifamily development should continue to decline in response to robust incoming supply and high interest rates.

Chart 9

Forecasting A First Rate Cut In December

We expect the Fed will await a flow of data that supports inflation consistent with its 2% target before considering lowering the federal funds rate. We believe that conditions for monetary policy easing won't be in place before autumn--and more likely not until very late in the year.

Inflation in May came in under the Fed's target on a month-over-month basis after four consecutive months of higher readings (see chart 10). One month doesn't make a trend, but it is a step in the right direction for eventual rate cuts.

Chart 10

We anticipate the Fed's preferred inflation gauge, the core Personal Consumption Expenditures deflator, to average monthly readings of around 0.2% for the remainder of the year, versus an average 0.3% in the first four months of 2024.

The first four months of inflation readings this year likely overstate the remaining excess inflation, but they still lowered our confidence in a rate cut happening soon. We now forecast the first rate cut in December--several months later than we had previously forecast, even as we acknowledge May inflation data brings a September rate cut into the discussion (see chart 11). Regardless, we project that a cooling economy into next year will bring about 100 basis points of rate cuts over the course of 2025, to 4.00%-4.25% at year-end.

Chart 11

And policymakers could, of course, wait even longer for inflation to come in consistently near the central bank's 2% target. This last mile could prove to be rough, given that there's no shortage of upside risks to our inflation outlook, including lingering excess demand and potential supply shocks that could stall disinflation.

That said, we don't think the Fed will feel the need to start hiking rates again. This was evident in its latest summary of economic projections as well. Monthly inflation may have come in too high to justify cuts, but it's also not enough to warrant further policy tightening.

Watching For Signs Of Labor Market Weakness

Now that inflation is under 3%, the Fed could become more sensitive to weakening in the labor market, which continues to rebalance. Job gains remain robust, at 249,000 (three-month moving average), versus 267,000 in the first quarter, according to the Bureau of Labor Statistics' (BLS) establishment survey (see chart 12). Unemployment insurance claims remain relatively low though have slightly drifted up recently.

Still, a number of other indicators show labor demand has inched down. The separately conducted BLS household survey suggested the number of people employed has stalled year to date, with the unemployment rate rising to 4.0% (from a 3.4% cycle low). The ratio of job openings to unemployed has fallen to near its pre-pandemic level. Small businesses' hiring plans have slumped, according to the National Federation of Independent Business (see chart 13).

Perceptions of job availability have deteriorated in turn. The share of consumers viewing jobs as "plentiful" in the Consumer Confidence survey is at its lowest level since early 2018, excluding the initial onset of the pandemic.

We suspect that these indicators are catching on to something that the establishment survey is missing. The most recent Quarterly Census of Employment and Wages suggests substantial downward revisions to nonfarm employment through December 2023 that are likely to be evident in the BLS' preliminary benchmark announcement in August.

The job openings rate and quit rate have normalized to pre-pandemic levels, and we think wage growth will decline toward 3.5% by next year (from 4.1% in May)--consistent with the 2% inflation target if we assume productivity growth of 1.5% (the 30-year average) and stable corporate profits.

Chart 12

Chart 13

Risks To Our Forecasts Are Balanced

In the near term, the Fed will remain focused on the economic data, in terms of how inflation influences the monetary policy outlook and to gauge the resilience of domestic demand and the labor market. While the economy's underlying growth potential will constrain any rise in spending, the lagged impact from fiscal policy should limit a cyclical slowdown in GDP growth.

Risks to our 2024 baseline growth forecasts are nearly balanced. Ordinary upside risks emanate from continuing strength in both private- and public-sector consumption while downside risk comes from elevated inflation and monetary policy biting more than intended. (See tables 3 and 4 for our optimistic and pessimistic scenarios based on ordinary risks surrounding our baseline GDP growth forecast.)

Key extraordinary downside risks include conflicts in the Middle East, heightened forms of protectionism post-election, and a potential resurgence in inflation that would threaten the Federal Reserve's expected monetary easing.

The Federal Reserve's latest Financial Stability Report--showing private-sector balance sheets are sound--provides some comfort but also comes with a warning about the debt-servicing capacity of smaller, riskier businesses in case of a sharp downturn in economic activity.

Table 2

Table 3

Table 4